China’s Deflationary Spiral Sounds Economic Alarm

China’s deflationary trend is exhibiting increasingly worrisome signs, posing a significant threat to its economic stability and necessitating urgent and decisive policy intervention. The severity of the situation has economists and policymakers alike on high alert, as the repercussions of prolonged deflation could reverberate throughout the global economy.

The Deepening Deflationary Cycle

The world’s second-largest economy is currently grappling with its most protracted period of deflation since the early 1990s, a concerning development that underscores the depth of its economic challenges. A more comprehensive indicator of economy-wide price trends, the gross domestic product deflator, is projected to have extended its downward trajectory for a sixth consecutive quarter in 2025, marking an unprecedented streak in recent history. Recent data unveiled on Monday painted a stark picture: barring food-related expenses, consumer price growth has remained stagnant or negligible across numerous sectors of the economy. This price stagnation is occurring against a backdrop of dwindling incomes, creating a perfect storm of economic headwinds.

Economic analysts have reached a consensus regarding China’s deflationary state, with many expressing grave concerns that the nation is now entering a more advanced and potentially perilous stage of this economic phenomenon. This transition signals a deepening of the deflationary cycle, with far-reaching implications for both domestic and international markets.

It is critical to recognise that China’s deflationary spiral has the potential to exacerbate rapidly. As households grapple with diminishing paychecks, there is a growing tendency to curtail spending or postpone purchases in anticipation of further price reductions. This behavioral shift could trigger a cascading effect throughout the economy. The repercussions may include a severe contraction in investments, precipitous declines in corporate revenues, further wage reductions, and a surge in unemployment rates. The cumulative impact of these factors could potentially lead to a wave of bankruptcies affecting both families and businesses, further destabilizing the economic landscape.

Indeed, preliminary findings from private sector surveys have already begun to indicate the onset of this snowball effect. In sectors traditionally favored by the government, such as electric vehicle manufacturing and renewable energy industries, entry-level salaries experienced a notable decline of nearly 10% in the past month compared to their peak in 2022. Another comprehensive survey revealed that the growth in labor costs during August was at its weakest since the initial easing of China’s Covid-related lockdowns in April 2020. These trends have sparked widespread concern among economists and policymakers, with many drawing parallels to Japan’s “lost decades” of the 1990s. During that period, Japan experienced persistent economic stagnation following the collapse of its real estate and financial market bubbles, a scenario that China now seems perilously close to replicating.

Policy Response and Challenges

Despite concerted efforts by Chinese officials to downplay discussions about deflation and caution analysts against employing the term, public awareness of the issue has grown significantly. The gravity of the situation now demands that policymakers prioritise addressing this economic challenge as a matter of utmost urgency. To combat the mounting deflationary pressures effectively, a two-pronged approach incorporating both proactive fiscal measures and accommodative monetary policies is essential. The immediate objective should be to reverse the negative trend in the GDP deflator, aiming to achieve positive growth in the coming quarters. This goal will require a comprehensive and well-coordinated economic strategy.

However, thus far, there have been no discernible indications that officials are prepared to deviate significantly from their current economic strategy. The existing approach primarily focuses on stimulating production rather than addressing the underlying issue of weak demand. Economists argue that more effective measures could include increased government expenditure on public services and the implementation of consumer subsidies to boost spending and economic activity.

Financial Market Implications

Further evidence of subdued price pressures can be observed in China’s core inflation rate, which excludes volatile components such as food and energy prices. This key economic indicator cooled significantly in August, reaching its lowest level in over three years. The persistent deflationary expectations are now spilling over into financial markets, fuelling a notable rally in the bond market. This has resulted in yields plummeting to historic lows, raising concerns among officials about banks’ exposure to interest rate risks. The situation underscores the complex interplay between deflation and financial market dynamics.

The impact of weak price pressures is starkly evident in China’s nominal GDP growth rate, which expanded by a mere 4% in the second quarter. This figure falls considerably short of the nation’s ambitious real economic growth target of approximately 5% for the current year. The disparity between nominal and real growth targets highlights the severity of the deflationary pressures facing the Chinese economy.

During periods characterised by weak price gains, economists emphasise that nominal expansion serves as a more reliable and insightful indicator of economic health. This is because nominal figures more accurately reflect the tangible changes occurring in wages, corporate profits, and government revenue streams. The current nominal growth rate, therefore, paints a concerning picture of the overall economic situation.

The repercussions of deflation are becoming increasingly apparent across the Chinese corporate landscape. Plummeting market demand is compelling firms to implement aggressive price cuts, often resulting in sales at a loss. This troubling trend, which has been ongoing since the previous year, has had a devastating impact on corporate income streams. Many businesses report that their revenues have plummeted to less than a tenth of their original levels. This dramatic reduction in income is making it exceedingly difficult for companies to meet their financial obligations, including crucial payments such as mortgage repayments and operational expenses.

Inflation Metrics: A Closer Examination

The rapid and severe deterioration in China’s price outlook has caught many market analysts and investors off guard, underscoring the unpredictable nature of the current economic climate. The speed and intensity of this deflationary trend have surpassed even the most pessimistic projections, leaving economists scrambling to reassess their forecasts and strategies.

Inflation figures have consistently underperformed market expectations in three out of the past four months, painting a bleak picture of price trends. In August, the overall inflation rate registered a meagre 0.6% growth, a figure that was primarily bolstered by a 2.8% increase in food prices. When examining core inflation, which provides a more stable measure of price trends by excluding volatile food and energy prices, the situation appears even more dire. Core inflation in August rose by a mere 0.3%, marking the 18th consecutive month where it has remained below the psychologically significant 1% threshold. This prolonged period of subdued core inflation is unprecedented in recent Chinese economic history and signals deep-seated deflationary pressures.

Further accentuating the deflationary forces at play, producer prices have been on a downward trajectory since the latter part of 2022. Official data reveals that manufacturers’ raw material costs and selling prices both experienced contraction for the second consecutive month in August. This trend is not limited to the manufacturing sector; services and construction companies are also feeling the pinch, with their charges shrinking at the most rapid pace observed since April 2020, during the height of the initial COVID-19 lockdowns. The widespread nature of these price declines across various sectors of the economy underscores the pervasive nature of the deflationary pressures.

The complexity of China’s economic predicament is further illustrated by a paradoxical situation in the country’s monetary policy. Some economists argue that even monetary expansion in China could potentially exacerbate deflationary pressures if it is primarily directed towards the supply side of the economy. This counterintuitive dynamic adds another layer of complexity to policymakers’ efforts to combat deflation effectively.

Shifting Consumer Psychology

As the deflationary environment persists, a concerning shift in consumer psychology is becoming increasingly evident. A deflationary mindset is taking root among the Chinese populace, with significant implications for economic behaviour and overall economic health. Consumer confidence has plummeted to record lows, reflecting widespread pessimism about the economic outlook. Simultaneously, households are reporting a growing preference for saving rather than spending or investing in real estate. This shift in consumer behaviour could create a self-reinforcing cycle of deflation, as reduced spending further suppresses prices and economic activity.

The human impact of these economic challenges is becoming increasingly apparent as the economic pain deepens and becomes more widespread. Many citizens are looking to Beijing for solutions, with a growing sentiment that concrete measures are needed to stimulate consumption and improve people’s expectations about the future. This call for action reflects the growing urgency for policymakers to address the deflationary spiral and restore confidence in the Chinese economy.

China’s deflationary spiral has entered a critical and potentially dangerous new phase. The persistence and intensity of deflationary pressures across various sectors of the economy pose significant challenges for policymakers, businesses, and consumers alike. As the situation continues to evolve, the need for decisive and effective policy interventions becomes increasingly urgent. The coming months will be crucial in determining whether China can successfully navigate these economic headwinds and return to a path of stable and sustainable growth.

A Trader’s View

China’s current deflationary spiral poses substantial economic challenges requiring careful navigation by the government. Addressing this issue involves tackling a complex array of factors, such as stabilising the struggling real estate sector, which has faced high-profile defaults and declining property values. Additionally, boosting domestic demand is crucial, given the weak consumer spending and cautious outlook. The government must also manage global uncertainties, including trade tensions and economic slowdowns. The success of the policies implemented to reverse deflation and ensure economic stability will be pivotal in determining China’s economic trajectory and its ability to sustain long-term growth and resilience.

Despite being available on the forex market, we don’t trade Chinese yen because it’s not regarded as a major pairing. We may examine the AUD, which is typically strongly associated with China. Let’s take a look at GBP/AUD which has the best trading setup for a short term trade based on technical analysis.

From the 4-hour chart, it is evident that the asset has been consolidating within a range for an extended period. After this prolonged period of sideways movement, a significant breakout has finally occurred. Currently, the price is retracing and moving back down to test the previous resistance level of 1.9528. This level is crucial, as it was once the point where the price struggled to break through. Our trading strategy involves placing a trade once the price shows a bounce off the 1.9528 level. A successful bounce would indicate that the previous resistance has transformed into a new support level.

This confirmation would signal a potentially favourable entry point for a trade, as it suggests a shift in market dynamics and a possible opportunity for further upward movement. The take profit level will be at 1.985 and the stop loss level will be at the previous low of 1.93; this will give us a good risk-to-reward ratio of 1/1.5.

Basil Goh